I just added a FAQ section on the right side of the blog. But I don’t plan to answer comments over there.
Today I’ll start with a very brief bio of four uber-important economists who were together at Princeton back around the turn of the century. Since I can’t go five minutes without talking about myself, I’ll add a brief explanation of how their work relates to mine. Then I’ll use their careers to speculate about what an ideal FOMC would look like. Keep in mind I don’t know any of these people, and thus the portraits will be very sketchy.
1. Michael Woodford
Woodford’s claim to fame is his book Interest and Prices, which has become the standard new Keynesian reference work for upper level macroeconomics. The book’s strength is the emphasis on expectations. Woodford shows that what really matters is not changes in the current stance of monetary policy, but rather changes in the expected future path of policy. The weakness is in the title. It’s a book about monetary economics that pretty much ignores money. Woodford sees interest rates as both the instrument of policy, and the transmission mechanism. If prices are sticky in the short run it is possible to do monetary theory this way. But there is no room for error. Thus if you get in a liquidity trap then the solution is to promise to hold interest rates at zero for an extended period of time. But this only works if you have an explicit inflation target. If you don’t have such a target (and we don’t) then promising to hold rates at zero for an extended period of time is indistinguishable from a promise to drive us right into a Japanese-style secular deflation.
What about me? Woodford and his co-author Gauti Eggertsson did some interesting work on the importance of policy expectations, particularly during liquidity traps. Gauti later discovered that I had done some work on the Great Depression that used this insight, although of course I lacked their sophisticated model. Gauti and I discussed these ideas by email, and he was kind enough to cite three of my Depression papers in his 2008 AER piece. In a 1997 paper co-authored by Bernanke, Woodford pointed to a circularity problem in my 1995 futures targeting model. But they failed to notice that there were two versions of my model, and that an earlier paper contained a version that was immune to this criticism.
2. Paul Krugman
Krugman’s claim to fame is his role as a public intellectual. He is the conscience of the Democratic party on economic issues, and the intellectual leader of the (old) Keynesian revival. His strength is his brilliance and his uncanny ability to see the essence of a public policy issue. He saw that the real danger was recession and deflation before most other economists, and saw that modern central banks were ill-equipped to handle a liquidity trap (something I missed.) One weakness is that he shoots from the hip too much. He offered a theory that a high wage policy might have promoted recovery from the Depression without bothering to check the data, which massively refutes this theory. Another weakness is that he sees issues in Manichean terms; good and evil. If you read his academic writings you’d think the best way out of the recession would be a bold policy of inflation targeting. But his passionate embrace of the social welfare state has led him to throw his lot in with fiscal expansion, and he has generally avoided the sort of thunderous moral condemnation of conservative central bankers that he routinely directs against conservative politicians.
What about me? Not much of a link. I did a paper in 1993 arguing that temporary currency injections would be expected to have little or no impact on the price level. In a much more sophisticated paper written in 1998, Krugman used a similar idea to explain the Japanese liquidity trap. Oh yes, I often criticize Krugman. But I have also said a number of good things about him. Of course some people are more likely to remember the bad things . . .
3. Ben Bernanke
Bernanke’s (original) claim to fame was his research on the Great Depression. His most influential paper was a study reviving Fisher’s idea of debt-deflation, and providing a more rigorous theoretical foundation for the idea that distress in the financial system could provide an independent channel through which deflation could impact the economy. Pretty ironic, eh? In my view his strengths lay elsewhere. He understood how high wages could have slowed recovery from the Depression, and also how unconventional techniques could allow monetary policy to be highly effective in a liquidity trap. His greatest weakness came out of his most famous paper. He overestimated the extent to which the financial crisis was reducing AD, and underestimated the extent to which falling AD was worsening the financial crisis. (See this earlier post, and also this great Congdon article that I hope to do a post on.) And as I mentioned, he and Woodford underestimated the potential of futures targeting, due to their worry about the “circularity problem.”
What about me? The only one of the four I’ve met. He was my first choice for Fed chairman. He’s read my Depression work and cited it. He and I have very similar views on the Great Depression, and did very similar research on gold ratios and what Bernanke called “multiple monetary equilibria” during the Depression. That’s when the same money supply might be compatible with two very different price levels, depending on expectations. Want an example? Think about what would happen if the monetary base stayed at this level and inflation expectations started rising.
4. Lars E.O. Svensson
Longtime readers of my blog may have noticed that Svensson’s name cropped up often in the first few months. I don’t think all that many of you (excluding professional economists) even knew who he is. His claim to fame is forward-looking monetary rules, that is, targeting the forecast. His strength is that he is one of the few economists to understand that all previous monetary targeting rules are mere stepping stones toward forecast targeting. Once you start thinking about policy this way, Taylor Rules and monetary aggregate targeting make no sense, they are clearly inferior to a policy rule that is expected to hit the policy target. His weakness is that he focused solely on forecast targeting policies using internal central bank forecasts (I presume he accepted Bernanke and Woodford’s flawed critique of futures targeting.)
What about me? In 1989 I wrote a paper envisioning a policy regime where central banks would target NGDP futures contracts. So do I deserve credit for the idea? Not really, Thompson (1982) and Hall (1983) got there before I did. Svensson also discussed “foolproof” escapes from liquidity traps, another area I have done research in. He cited the example of FDR’s program of dollar depreciation, something I have also studied extensively. And finally, there is the negative interest on bank reserves policy recently adopted by Sweden. I am pretty sure that it was Svensson’s idea. And which blog has been promoting this idea relentlessly all year? Are you beginning to understand why I found Svensson so intriguing? This further strengthens my conviction that once you start looking at the world from the perspective of targeting the forecast, the field of monetary economics looks very, very different.
What got me thinking about these four is the recent story that Svensson dissented from the Riksbank’s recent policy statement. But not because the decision to cut rates to 0.25% was too bold a move, rather because it wasn’t bold enough. It seems Svensson wanted to reduce the lending rate to zero, and one report suggested he wanted a penalty rate of 0.5% on reserves. That’s my kind of central banker! I have a source that tells me Svensson is known as favoring a more aggressive policy that Bernanke. He speculates these two may keep in touch, but isn’t sure.
This made me wonder what qualities we should look for in a central banker. And the more I thought about it, the further I ended up from my normal populist instincts. Senator Hruska may have been right about the acceptability of mediocre justices on the Supreme Court, but we can’t afford mediocre FOMC or ECB members.
Although Svensson’s views are closest to my own, I’m not so delusional as to think that we should have 12 Scott Sumner clones on the FOMC. What if I am wrong? A diversity of opinion is essential to any well run committee; otherwise you might as well turn things over to a dictator. (Compare China’s economy under Mao to the current committee-run regime.)
So let’s imagine an FOMC with the above 4 members, plus a bunch of other distinguished monetary economists; say people like Mishkin, Mankiw, Rogoff, Hall, McCallum, James Hamilton, etc. I don’t want any inflation hawks or inflation doves; I want people who call for tight money when tight money is needed and easy money when easy money is needed. And most importantly, nobody who believes monetary policy is ineffective in a liquidity trap. (Yes, I’m talking about Janet Yellen.)
Here’s my hypothesis. A committee made up of these 10 people would have been far more likely to adopt a highly expansionary monetary policy once the scale of last fall’s crash became apparent. There’s enough intellectual firepower there to understand the threat of rapidly falling NGDP, and also the need for policy credibility. I think they would have been able to coalesce around something like the 3% inflation trajectory (level targeting) proposed by Mankiw in his blog.
Monetary policy is incredibly complex. You have to look at issues from a lot of different perspectives. My fear is that even fairly bright people may get stuck in an intellectual rut, looking at policy from just one perspective. Good isn’t good enough, bright isn’t bright enough, we need people who are extremely bright, but also have the kind of mind that allows them to see the problem from different angles.
And here’s another hypothesis. Monetary policy may be the only important policy area where this is true. In other areas like health care, we don’t let a bunch of “wise men” (and women) make important decisions, rather we let Congress and the President decide. (Go ahead, insert a joke here.) The Supreme Court might be the closest parallel, but a mistake by the Supreme Court generally won’t create a worldwide recession, or depression.
And here’s another hypothesis. The Great Depression was caused by our failure to have the best and the brightest in charge on monetary policy. The western world needed people like Fisher, Keynes, Cassel, Hawtrey, Robertson, Einzig, etc, on their monetary policy-making committees. The US did have a great central banker in the 1920s, Governor Strong of the New York Fed. By force of personality Strong was able to dominate a bunch of incompetent hacks who stayed out of his way and let him run the show.
I am reading Lords of Finance (recommended to those interested in monetary history), and recently ran across this comment about Governor Strong:
“The two main domestic indicators that Strong had come to rely on to guide his credit decisions—the trend in prices and the level of business activity—argued that the Fed should ease.”
Note that he is talking about inflation and RGDP growth. And what is the sum of inflation and RGDP growth? You guessed it, NGDP growth. Strong died in late 1928. When I first read Friedman and Schwartz argue that things might have been much different had Strong lived I was dubious. Then I later came across the same comment from two other economists that I greatly respect; Irving Fisher, and Ralph Hawtrey. Keynes also was a big fan of Strong. Then I came across this passage from Lords of Finance describing Fed policy in the summer of 1930:
In the early summer the Fed stopped easing. It proved to be a mistake. For just as it went on hold, the economy embarked on a second down leg, industrial production falling by almost 10 percent between June and October. There is some debate about Harrison’s reasons. [Harrison replaced Strong.] Some argue that he thought he had done enough. Having staved off catastrophe by pumping a large amount of money into the system and cutting rates to an unprecedented low level, he believed that he had been as aggressive as he could. Others argue that he was operating with what might be called a faulty speedometer for gauging monetary policy. The usual indicators that he relied upon suggested that conditions were very easy—short-term rates were truly low and banks flush with excess cash. The problem was that some of these measures were no giving off the wrong signals. For example, when banks overflowed with surplus cash, this was generally an index, in a more stable and settled economic environment, the Fed had pushed more than enough reserves into the system to restart it. In 1930, however, in the wake of the crash, banks had begun carrying larger cash balances as a precaution against further disasters, and excess bank reserves were more a symptom of how gun-shy banks had become and less how easy the Fed had been.
Thank God we no longer have central banks thinking that during a period of rapidly falling NGDP it is enough to reduce interest rates to very low levels and pump lots of cash into the system!
Oh wait . . .
Seriously, when I read this I was struck by how similar it was to what I have been saying. Not just one or two sentences, but all of it. Someone either understands that the only reliable speedometer is NGDP (or inflation) or they don’t. Governor Strong got it. So did the author of Lords of Finance (Liaquat Ahamed), and so did Friedman and Schwartz. Strong’s death really was a tragedy.
The elite bankers and financiers of Wall Street were pretty smart people. So were the central bankers of the US, Britain, and France. But they weren’t smart enough. After Strong died the best central banker was probably Montegu Norman, but the central bank he led (in England) lacked the gold reserves to decisively influence world conditions. Today the world’s best central banker might be Lars Svensson, but he can’t even muster a majority in Sweden.
So the wealthy conservatives of the interwar period who dominated central banking dug their own graves, and the graves of millions of others. Not through greed but through ignorance. The few people who were able to see the big picture; Keynes, Fisher, Hawtrey, etc, did not have a voice in policy.
I don’t care how much is costs, even if we have to pay FOMC members a billion dollars a year, we will save much more money in the long run if we can get “strong” central bankers (pun intended) who have the vision to see what needs to be done, and who understand that effective policies require explicit target paths for macro aggregates
And a message to my Congressman, Barney Frank. Stop telling Bernanke he can’t adopt an explicit inflation target. You are in way over your head, and have no idea how much damage is done by your interfering in monetary policy.